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VAT: An Explanation

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VAT: An Explanation

Many of the first analyses of the DBCFT immediately noted the similarities to the value added tax (VAT) that is a key part of the tax base in Europe and other places.

Ultimately, they aren’t the same. The VAT is a consumption-based tax; there is little disagreement on the fact that the consumer of a product pays. The DBCFT, however, is the basis for a corporate income tax structure.

Still, the VAT-like principles of the DBCFT are important, and require a look at what the VAT is, and where there are differences with the Republican reform proposal.

The VAT is a broad-based tax on final consumption. VAT is usually collected in stages by enterprises through the supply chain. The tax is levied on value added, i.e. revenues from a sale of a product minus the costs of the intermediate inputs that have been used to produce a good or service. In practice, each firm pays the difference between the VAT on their sales and the VAT on their purchases. Ultimately this tax is fully borne by the final purchaser, which in most cases is a private individual.

The VAT is broad-based in that it is not levied on specific products or services, but on virtually all of them. Some exemptions do exist, however.

Although the VAT tends to be associated with Europe, the fact is it’s part of the tax system in more than 120 countries. VAT rates vary widely, from 5% in Canada, 8% in Switzerland and Japan, rising to 27% in Hungary. The unweighted OECD average in 2015 was 19.2%. The intake from the VAT varies, depending on the tax rates and a country’s level of consumption. New Zealand, Denmark and Hungary have the highest intake among the OECD economies, about 9.5% of GDP in VAT. On the opposite end, Australia and Switzerland collect only 3.5% of GDP in VAT. And for countries such as UK, Germany and France the share is about 7% of GDP.

One similarity between a VAT and a DBCFT is the treatment of imports and exports. By subjecting imports to the VAT, and exempting exports, it is true to the destination principle: tax only those goods consumed in the taxing authority. It is that similarity, more than anything else, that has raised the VAT-DBCFT comparisons.

The application of the destination principle in VAT achieves neutrality in international trade, as it ensures a level-playing field for all firms--domestic and foreign--competing in a particular jurisdiction. By counting imports into the base and leaving out exports entirely, VAT is neutral as to whether a product consumed locally was produced at home or imported from elsewhere. And if it was produced at home and exported elsewhere, it isn’t subject to VAT in the home country.

There has long been a debate among public policy experts and economists about the least-intrusive and distortive way for government to fund itself. The most widely held consensus is that consumption taxes, as opposed to incomes taxes, are more conducive to economic growth, because they least interfere with the decisions of economic agents to supply labor, to save and to invest. That was a theme in a significant OECD study of 2008. However, the study does acknowledge the issue of consumption taxes being less progressive than income taxes, or even regressive. (By contrast, the author of the paper that establishes the intellectual foundations for the DBCFT, Professor Alan Auerbach, refers to the DBCFT as “a highly progressive instrument of tax policy…imposing a tax on consumption (not) financed out of wage and salary income.”) Shifting part of the revenue base from income taxes to less distortive taxes such as VAT can therefore be considered as a revenue-neutral growth-enhancing tax reform, which however tends to increase income and wealth inequality.

While Auerbach’s DBCFT has VAT similarities, they aren’t identical. In countries that rely on VAT, they usually have a corporate income tax as well. Under the GOP Blueprint, a VAT-similar plan would be replacing the corporate income tax, without any sort of concurrent national consumption tax.

Some of the similarities between VAT and DBCFT may prove to be problematic relative to the rules of the World Trade Organization. For example, while the VAT is undoubtedly a consumption tax, the Republican DBCFT is not. That may result in a WTO ruling that its exclusion of exports from the tax base amounts to a subsidy, which is illegal under WTO rules. The deductibility of exports in a consumption tax is viewed as hewing to the destination principle, so it isn’t considered a subsidy.

Another notable difference between VAT and DBCFT as proposed in the Republican Blueprint--which lines up with the Auerbach proposal--is the deductibility of labor. Labor costs are not deductible in the VAT.

But even if the Republican Blueprint is adopted as it, those issues might not be a death knell despite an apparent conflict with WTO rules. As the law firm of White & Case noted in a recent publication, “Many WTO Members…adopt measures that they suspect – or know – to be problematic under WTO rules, but determine that such policies likely will not be challenged, including for diplomatic reasons, or that the legal risks are outweighed by political or economic considerations.”

Regardless of how the implementation plays out, it’s clear that the principles governing VATs will never be far from consideration of the acceptability of making Auerbach’s DBCFT the basis for a corporate tax overhaul.